Last week, we discussed position sizing for simple option trades. This week, we discuss position-sizing for spread trades such as bull call spreads, bear put spreads and ratio spreads.
Ten per cent rule
Position-sizing refers to determining the optimal number of contracts to trade, given your view on the underlying. Position-sizing for spot transactions must be based on the risk per unit of trade, the maximum risk you intend to take on a single transaction and your trading capital. For options trade, you must also consider the permitted lot size.
To recap last week’s discussion, position-sizing for underlying is based on two per cent rule — you should risk only two per cent of your trading capital on a single trade. Position-sizing for simple option trades (such as long calls) could be based on 10 per cent rule, given that the two per cent rule could lead to position size that may be lower than the permitted lot size for option contracts.
Suppose you have a positive view on the Nifty Index. Further suppose you determine a resistance level of 17,676 based on the one-month futures contract. Note that the resistance level for an index is based on its futures contract as the spot index is not tradable. Now, suppose you decide to set up a bull call spread, going long on the 17,400 call (with the spot currently at 17,306) and short on 17,800. Note that the spread is long a call that is one tradable strike away from the current spot price and short a call that is one tradable strike higher than the resistance level.
How should you position-size your trade? Suppose you determine the stoploss for the Nifty futures as 17,212. With the Nifty February futures currently trading at 17,333, the downside risk is 121 points. This must be translated into price movement for the option position. To do so, you must multiply the option delta with the expected decline in the underlying. Note that delta only captures the approximate change in the option price for a one-point change in the underlying. This means that the delta will be far from accurate for a large change in the underlying.
The delta of long 17,400 call is 0.50 whereas the delta of the short 17,800 call is 0.29. So, the bull spread has net delta of 0.21 for a one-point change in the underlying. The difference between simple option trades and spread trades is that you must take the net delta for spreads.
With a stop-loss of 121, the risk on the spread translates to 37 points (121 times 0.21). Given the permitted lot size of 50, the risk is 1,850 per contract. Applying the 10 per cent rule on a trading capital of two lakh, you cannot risk more than 20,000 on this trade. Therefore, your position-size is a maximum of 10 spread contracts.
The actual number of contracts you decide to buy should depend on how confident you are about the trade. Two questions are relevant. One, is the chart pattern suggesting a convincing price breakout? And two, do you have a reward-risk ratio of at least two?
Position sizing option contracts depends on delta — larger the delta, lower the position size. It is important to note a characteristic of spread trades. The delta of a call option increases faster when the underlying moves up than it decreases when the underlying declines for the same magnitude change in the underlying. This is because the gamma (positive for long position) accelerates the option delta when the underlying moves up and slows down the delta when the underlying declines. This is beneficial for position-sizing long spreads because of the lower delta on the downside. Given that the delta is only an approximation, you could adjust the delta with the gamma to reduce the approximation error.
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